Stabilization with Fiscal Policy
I reconsider the long-standing consensus view that macroeconomic stabilization should rely on monetary policy, not fiscal policy. I use an analytically tractable heterogeneous agent New Keynesian (HANK) model that is parameterized so as to admit a bubble in public debt. In this context, I show that it is possible to stabilize either inflation or output in response to aggregate shocks by varying only fiscal policy (that is, lump-sum uniform transfers). In contrast, when the public debt bubble is large, it is impossible to stabilize either inflation or output by varying only interest rates (monetary policy). The theoretical analysis implies that, in the presence of a large public debt bubble, fiscal policy is a more reliable stabilization tool than monetary policy.
The views expressed herein are those of the author and do not necessarily reflect the views of the National Bureau of Economic Research.